Pamper Your Portfolio With This Beauty Stock

by Will Ashworth | November 29, 2011 2:59 pm

Pamper Your Portfolio With This Beauty Stock

Ulta Salon, Cosmetics & Fragrance Inc. (NASDAQ:ULTA[1]) currently is ranked No. 2 on Investor’s Business Daily’s list of the 50 best stocks. Ulta’s business is booming. Last quarter, sales and earnings increased 23% and 73% year-over-year, respectively. Fourth-quarter earnings, expected Dec. 1, should be much the same.

Despite all the good news, investors might want to ditch the beauty salon business and focus exclusively on the hair care and beauty products — and more importantly, the stock — offered by Sally Beauty Holdings (NYSE:SBH[2]). The former Alberto Culver subsidiary might have a lot of debt, but it’s a much better buy. I’ll explain why.

Profitability

Normally, I’m not keen on investing in companies whose level of debt is unusually high. However, I’m willing to make an exception for Sally Beauty Holdings because of its profitability. Since Sally was spun out of Alberto Culver in November 2006, its gross margins have increased 300 basis points to 48.8% and its operating margins 610 basis points to 13.7%. These are substantially higher than ULTA’s margins, which are at their highest levels ever.

Sally makes 44% more than Ulta for every dollar of revenue. Therefore, as long as Sally continues to grow revenues 5% to 10% per year, the debt problem will take care of itself.

Growth

I’ve already shown that Sally is more profitable. However, margins aren’t everything. Growth also is meaningful, so why don’t we have a look at that side of the coin?

Everything about Ulta suggests it’s a growth company. Revenues have grown an average of 20% annually over the past five years. Sally, on the other hand, has plodded along at 6% annually.

Using their trailing 12-month revenue numbers, let’s figure out how much money each company will be earning five years from now. At 20% revenue growth, Ulta’s revenues in 2016 would be $4 billion. Sally’s revenue in 2016, based on 6% growth, would be $4.4 billion. Assuming the same margins as today, Sally would earn $599 million in 2016 — $161 million more than Ulta.

Fans of Ulta could argue that its operating margin will be higher than 9.5% in five years given its current growth in earnings. That’s true, but the same can be said for Sally, which actually has increased margins since 2006 at a rate equal to or slightly better than Ulta.

Valuation

Ulta currently trades at 47 times earnings. Its forward P/E is 31.7, based on January 2013 EPS of $2.18. Another fast-moving specialty retailer, Lululemon (NASDAQ:LULU[3]), has a similar forward P/E ratio. But here’s the difference: Lululemon has an operating margin of 27.7%, three times Ulta’s. Either the activewear phenom is incredibly undervalued and Ulta is fairly valued, or Lululemon is fairly valued and Ulta is incredibly overvalued. My guess is the truth is somewhere in the middle, and both stocks are a little rich.

Sally, on the other hand, could be considered a GARP stock in that it’s growing at a decent clip and yet has a September 2013 forward P/E of 13.4, only slightly higher than the forward P/E for the S&P 500.

By every valuation metric, Sally is a better deal. One metric that almost every investor will ignore in this instance is the Graham Number, a quick and easy way to determine the fair value of a stock. The reason most will ignore this calculation — besides the fact it’s old-school — is that Sally has negative shareholder equity resulting from its $25 special cash dividend in 2006 to Alberto Culver shareholders. As a result of this dividend payment, Sally doesn’t show up on most stock screeners for anything related to book value.

But if you add back the $25, SBH’s current book value per share is $23.81. Multiply that by its trailing 23-month EPS of $1.14 and 22.5 (P/B and P/E guideline) and you get a fair value of $24.72 per share, 28% higher than its Nov. 28 closing price of $19.33. Doing the same thing for Ulta, we come to a fair value of $16.07 per share, 77% lower than its Nov. 28 closing price of $68.45. By Ben Graham’s standards, Ulta clearly is the mispriced stock.

Bottom Line

Ulta promotes itself as a “beauty destination” where women can go to one-stop shop for all their hair care and beauty product needs. By including an actual hair salon in its stores, it might increase the customer experience, but it definitely decreases profitability. For proof of this, look no further than Regis Corp. (NYSE:RGS[4]), whose business model consolidating the salon business isn’t working.

If you must overpay for a stock, buy Lululemon. Otherwise, forget Ulta despite its booming earnings and invest in Sally Beauty Holdings instead. In the long term, Sally has the more sustainable business model.

As of this writing, Will Ashworth did not hold a position in any of the aforementioned stocks.